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Subject 1. Pricing and valuation
Swap pricing means to determine the fixed rate and any relevant terms, such as the foreign notional principal on a currency swap, at the start of the swap.
All swaps have a market value. Swap valuation means to determine the market value of the swap, which is the present value of one stream of payments less the present value of the other stream of payments.
- The fixed terms, such as the fixed rate, are established at the start to give the swap an initial market value of zero. At this point neither party pays anything to the other. It is neither an asset nor a liability to either party.
- The market value of a swap will change to positive for one party (an asset to that party) and negative for the other (a liability to that party) during the life of the swap, as market conditions change and time passes.
To determine the market value of a swap, we replicate the swap using other instruments that produce the same cash flows. Knowing the values of these instruments, we are able to value the swap. This value can be thought of as what the swap is worth if we were to sell it to someone else. In addition, we can think of the value as what we might assign it on our balance sheet. The swap can have a positive value, making it an asset, or a negative value, making it a liability.
Study notes from a previous year's CFA exam:
a. distinguish between the pricing and valuation of swaps;